Steve Burke, Corporate Attorney, Williams Mullen
If you are starting a new business, one of the many important decisions you face is the type of entity you choose for operating the business. While there are many available entity types, the most common are corporations and limited liability companies (or LLCs).
These entities are governed by laws of the state in which they are formed. For practical reasons, you should choose forming an entity in the state where the principal operations of the business are located, or in Delaware. Forming an entity in the home state of your business is generally less expensive over the long term. Many investors and lawyers choose to form their entities in Delaware because they are familiar with Delaware law regarding corporations and LLCs and because Delaware has developed a significant body of law that applies to these entities, especially to corporations.
A corporation may be a C corporation or S corporation for federal and most state income tax purposes. The “C” and “S” designations refer to subchapters of the Internal Revenue Code and affect the tax status of the corporation. C corporations and S corporations are not special types of corporations under state corporate laws.
C corporations are taxpaying entities. In addition, if a C corporation makes distributions (dividends) of its earnings and profits to its shareholders, those dividends generally are taxable income to the shareholders. This results in what is often referred to as “double taxation.” There are very few restrictions in the Internal Revenue Code on who can be a shareholder of a C corporation and what it can own.
Generally, S corporations are pass-through entities for income tax purposes. Income, loss, credit and deduction pass through to the shareholders of S corporations in proportion to their stock ownership and the S corporation is not a taxpaying entity. Generally, dividends to shareholders of S corporations of earnings that already have been passed through to the shareholders are not taxed a second time. A corporation must file an election with the IRS to become an S corporation and there are many restrictions under the Internal Revenue Code on who is qualified to be a shareholder of an S corporation and what an S corporation can own. If the corporation and its shareholders do not comply with these rules, an S corporation can become a C corporation.
LLCs can elect to be taxed as a C corporation, an S corporation or a partnership for federal and most state income tax purposes. Most often, LLCs are taxed as partnerships, which also are pass-through entities. LLCs, unlike S corporations, can have multiple classes of membership interests that can have different rights and privileges. As with S corporations, earnings that already have been passed through to an LLC’s members generally are not subject to double taxation.
In addition to different income tax treatment, corporations and LLCs differ under state laws. Generally, LLCs can have a much more flexible structure than corporations. Because of this flexibility, most LLCs operate under a limited liability company agreement or operating agreement that governs all aspects of the ownership and operations of an LLC. LLCs are becoming more popular because of the single level of tax and the great amount of flexibility they give to their owners.
Generally, there are fewer tax consequences in converting an LLC that is taxed as a partnership into a corporation than in converting a corporation, whether a C corporation or an S corporation, into an LLC.
Owners of corporations and LLCs should not be held personally liable for the entity’s liabilities if statutory formalities are followed and the owners do not commingle their personal assets with the assets of the entity.
One of the most important factors to consider in forming an entity is how it will be taxed on the eventual sale of the business or its assets. The major disadvantage of forming a C corporation is the potential for double taxation if the purchaser of the business wants to buy the assets of the business in a taxable transaction.
Most S corporations and LLCs do not have this double taxation issue. Generally, on the sale of identical businesses, the owners of an S corporation or LLC will receive more after-tax proceeds than the owners of a C corporation will receive.
In summary, the type of entity you select will affect your future tax liability, ownership rights and flexibility in business operations, so be sure to give the choice of entity careful consideration.
About the Author
Steve Burke is a corporate attorney at Williams Mullen, where he helps business owners and executives analyze and solve complicated business, tax and legal issues related to the formation, structuring, financing or refinancing of businesses. He also assists them with the sale of their businesses or the acquisition of other businesses. Steve can be reached at (757) 473-5332 or sburke@williamsmullen.com.
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